running head: the microsoft corporation – company analysis...

The Microsoft Corporation

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Running head: THE MICROSOFT CORPORATION COMPANY ANALYSIS

The Microsoft Corporation Company Analysis

Arman Kanooni

Capella University

OM7040 Fundamentals of Financial Management

Professor: Dr. Dennis Huber

Mars 20, 2006


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Abstract

A group of investors has approached us for advice on an investment in the Microsoft

Corporation. The investors want detailed research on the company, including its financial

strengths and weaknesses, position in the market, and potential for growth. They want us to

analyze the data we collect and make recommendations as to whether they should invest in the

company. We will provide sound analysis and data to support our recommendation.


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Introduction

Microsoft Corporations headquarter is in Redmond, Washington and started mainly as a

software development company creating operating systems for personal computers (PCs) and

office productivity software for PCs. Today this company is developing and supporting many

software products for various computing devices worldwide. MSFT (2006) identified seven

major product segments within the Microsoft Corporation: 1) Clients, 2) Servers and Tools, 3)

Information Worker, 4) Microsoft Business Solutions, 5) MSN, 6) Mobile and Embedded

Devices, 7) Home and Entertainment.

The Microsoft technical innovations and its leadership in consumer markets and

corporate markets make them a redoubtable competitor in this information age. In this paper, a

financial analysis of the Microsoft Corporation is conducted based on the publicly available

financial data for the last five years and a recommendation will be made for an investment

strategy based on Microsofts track record. The reader should not judge the future gain or loss

based on the past performance, since it is impossible to predict the future. Thus, please use your

common sense to adjust the financial decision based on market conditions and other factors

beyond the control of this study.

Company Profile

Index Membership

This company is member of New York Stock Exchange (NYX).

Sector of activity and Industry

Based on MSFT (2006), the Microsoft Corporation is operating in the technology sector

and is active in application software industry.

Number of divisions and employees


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The Microsoft (2006) has seven divisions and 61,000 employees. There are 39,000

employees in the United States and 22,000 all over the world. There are 24,000 individuals in

research and development, 18,000 in sales and marketing, 12,000 in product support and

consulting services, 2,000 in manufacturing and distribution, and 5,000 in general and

administration.

Business Summary

Segment Revenue

The following table 1 shows the segment revenue for the MSFT (2006) for last 3 years.

Table 1 Microsofts Segment Revenue ((In millions)

Segment Revenue 2003 2004 % 2004 vs. 2003 2005 % 2005 vs. 2004

Client 10,304 11,283 10% 12,048 7%

Server & Tools 6,786 8,007 18% 9,143 14%

Information Worker 9,636 10,895 13% 11,523 6%

MS Business Solutions 641 753 17% 793 5%

MSN 2,396 2,444 2% 2,411 -1%

Mobile Embedded

Devices

153 239 56% 334 40%

Home & Entertainment 2,779 2,870 3% 3,211 12%

Reconciling amount (508) 344 325

Consolidated 32,187 36,835 14% 39,788 8%

The consolidated revenue was up by 14% in 2004, but the growth was a bit slower at 8%

in 2005. As far as the revenue by segment of activity is concerned, there were remarkable


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revenue growths for the mobile and embedded devices with 40% increase, the server and tools

with an increase of 14%, and the home and entertainment segment with 12% increase compare to

2004. In opposite side, the Internet service provider MSN lost some revenue in 2005 by 1%.

Graph 1 Plot of Microsofts Segment Revenue

Clie

nt

Info

rmat

ion

Wor

ker

MSN

Hom

e &

Ente

rtain

men

t 2003(2,000)

02,0004,0006,0008,000

10,00012,00014,000

200320042005

2003 10,304 6,786 9,636 641 2,396 153 2,779 (508)

2004 11,283 8,007 10,895 753 2,444 239 2,870 344

2005 12,048 9,143 11,523 793 2,411 334 3,211 325

Client Server & Tools

Information

Worker

Microsoft Business Solutions

MSNMobile

Embedded Devices

Home & Entertain

ment

Reconciling

amount

Finally, in 2005 over all consolidated revenue is increasing by 8% compare to 2004, but

still lower compare the 2004s revenue increase of 14%.

Net Operating Income/Loss

The net operating income or loss for last 3 years is shown in the following table 2:

Table 2 Microsofts Net Operation Income/Loss (In millions)


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2003 2004 % 2004 vs.

2003

2005 % 2005 vs.

2004

Client 8,306.00 8,975.00 8% 9,396.00 5%

Server & Tools 1,879.00 2,302.00 23% 2,888.00 25%

Information Worker 7,500.00 8,112.00 8% 8,616.00 6%

MS Business Solutions (143.00) (115.00) 20% (163.00) -42%

MSN (384.00) 383.00 200% 469.00 22%

Mobile Embedded Devices (162.00) (98.00) 40% (19.00) 81%

Home & Entertainment (938.00) (894.00) 5% (359.00) 60%

Reconciling amount (6,513.00) (9,631.00) (6,267.00)

Consolidated 9,545.00 9,034.00 -5% 14,561.00 61%

Graph 2 Microsofts Net Operation Income/Loss

(10,000.00)

(5,000.00)

0.00

5,000.00

10,000.00

Client InformationWorker

MSN Home &Entertainment

2003

2005

200320042005

In term of net operation income or loss, there are mixed results. The client and

Information Worker segments are strong and the net operation income is increasing each year at


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average rate of 7%. The server and tool segment is strong with 24% average growth. The MSN

segment is strongest with 200% increase in 2004 and 22% in 2005. In the negative side, one can

observe the net operating losses continues from 2003, 2004 to 2005 in Microsoft Business

Solution, Mobile Embedded Devices, and Home and Entertainment.

Stock price movements

The table 3 shows the snapshot of MSFT as of March 2nd, 2006. (Big Charts, 2006).

Table 3 Microsofts Stock Price Movements

Last: Change: Open: High: Low: Volume: -0.17 27.02 27.1001 26.90 41,856,388

Percent Change: Yield: P/E Ratio: 52 Week Range: 26.97 -0.63% 1.33 22.48 23.82 to 28.38

Graph 3 MSFTs stock price movements for last five years.


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You can observe a dramatic stock devaluation of Microsoft in 2002. This corresponds

with the overall US economic slowdown, the aftermath of September 11th, 2001 terrorist attacks

and the loss of investors confidence in the high technology sectors and the dot com companies.

Dividend payments

Based on statement of cash flows (Exhibit 6), the Microsoft Corporation didnt pay any

dividends for 2001 and 2002. But they paid the amount of $857 million, $1,729 million, and

$36,112 million respectively for 2003, 2004, and 2005.

Financial Statements

Income Statement

Exhibit 1 provides the Microsoft Corporations income statements from 2001 to 2005.

Revenues are shown at the top of income statement, after which operating expenses, interest

costs, and taxes are subtracted to obtain the net income available to common shareholders, which

are referred to as net income. The revenue grown has been accelerating at a rate of 13% per year

on average. This seems to be a normative growth rate based on five years of data. This growth is

significantly lower than the 10 year average growth of 23% (Yahoo, 2006). However, it is still

solid growth.

Earning per share (EPS) or the bottom line shows $1.13 per share in 2005, up from

$0.76 in 2004, and it is up from $0.70 in 2003.

Dividends per share (DPS) indicate that in 2001 and 2002, Microsoft didnt pay any

dividends to shareholders. In year 2003 the DPS was $0.08. It doubled in 2004 to $0.16 and

jump to $3.33 for 2005.

Book value per share (BVPS) for the year 2001 was $4.43 and the average market value

per share was $33.20. Therefore the market value per share versus book value per share ratio was

around 7.50 times. This ratio was 5.25 times in 2002, 4.54 times in 2003, 3.82 times in 2004,


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and 5.87 times in 2005. This indicates that Microsoft achieved high rates of return on their assets

causing their market values to be well above of their book values.

For the past five years, research and development expenses are around 17% of revenue

in 2001, 15% in 2002, 20% in 2003, 21% in 2004, and 16% in 2005.

General and administrative expenses are growing from 3% of revenue in 2001 to 5% in

2002, 8% in 2003, 14% in 2004, and 10% in 2005. The large increase in 2004 is attributable to

legal expenses of $1.92 billion to settle the Sun Microsystems case, a $605 million fine imposed

by the European Commission, and $280 million of stock-based compensation.

The cost of revenue was 14% of revenue in 2001, 18% in 2002, 19% in 2003, 18% in

2004, and 16% in 2005.

The sales and marketing was 19% of revenue in 2001, 19% in 2002, 23% in 2003, 23%

in 2004, and 22% in 2005.

The most current growth rates per percent of Microsoft compared to the industry and the

S&P 500 (MSN Money Central, 2006) is shown in the table 4.

Table 4. Growth Rates %

Growth Rates % Company Industry S&P 500

Sales (Qtr vs year ago qtr) 9.40 1.80 10.70

Net Income (YTD vs YTD) 13.40 36.90 17.70

Net Income (Qtr vs year ago qtr) 5.50 -8.90 20.00

Sales (5-Year Annual Avg.) 11.07 2.77 5.12

Net Income (5-Year Annual Avg.) 7.99 12.25 15.23

Dividends (5-Year Annual Avg.) NA NA 7.96


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Balance Sheet

The balance sheet statement is presented in Exhibit 3 which shows the Microsoft

Corporations assets from 2001 to 2005. The assets are listed in order of their liquidity.

1. Cash versus other assets. The cash and short term investments were $31.6 billion in

2001, $38.6 billion in 2002, $49 billion in 2003, $60.5 billion in 2004, and $37.7 billion in 2005.

There is a general trend of growing cash from 2001 up to 2004. In 2001, the cash and short term

investments represented 53.7% of total current assets, 57.1% in 2002, 60% in 2003, and 64.2%

in 2004. But, this trend came to a decline in 2005 with cash representing 53.3% of total current

assets. The net total receivables were $3.6 billion in 2001, $5.129 billion in 2002, $5.196 billion

in 2003, $5.89 billion in 2004, and $7.18 billion in 2005. The percentage of total receivables

compare to the total current assets is 6.2% in 2001, 7.6% in 2002, 6.4% in 2003, 6.2% in 2004,

and 10.1% in 2005.

2. Liabilities versus stockholders equity. The claims against the total current assets are

represented by the total liabilities providing the net worth as indicated in table 5.

Table 5 Microsofts Net Worth

Year 2001 2002 2003 2004 2005

Total current assets $39,210 $48,576 $58,973 $70,566 $48,737

Minus Total Liabilities $11,541 $15,466 $16,820 $19,543 $22,700

Net Worth $27,699 $33,110 $42,153 $51,023 $26,037

Cash Flow

The cash flow statement is presented in Exhibit6. Cash flow from operations increased

from $14.626 billion in 2004 to $16.605 billion in 2005.


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Cash flow from financing is negative and went up by $39 billion in 2005. This due

primary to $36.112 paid dividends to the shareholders.

Cash flow from investing was very positive in 2005. It went from ($3.345) billion to

$15,027 billion. The increase in cash flow from financing is attributable to a shift in duration of

investment held. Long-term maturities were exchanged for more liquid investments.

Financial Ratios Analysis

The purpose of this section is to evaluate and interpret the results, especially with respect

to the financial statements.

Liquidity Ratios

Brigham & Houston (2004) argue that liquidity shows how a firm can meet its short-term

obligations using assets that could be converted into cash in a short period of time. These liquid

assets are listed in the balance sheet as current assets. They are used to meet current liabilities.

Now, the question is how much liquidity a firm must have? To answer this question, one has to

consider the role of the operating cycle. This is the time it takes to invest in firms products and

services to the time when investment generates cash. The net operating cycle is the duration of

time it takes to convert an investment of cash in inventory and back into cash. So, the number of

days a firm holds its fund in inventory is calculated by the following formula:

The inventory turnover ratio of the Microsoft Corporation for last five years is shown in the

table 6. There is a remarkable improvement from 2001 to 2002 going from 41.63 days to 7.71 days.

In 2004, the inventory turnover increased to 15.95 days, but the trend reverses itself in 2005 and

stayed at 12.63 days. The industrys inventory turnover ratio is 28.4 and 8.4 for S&P 500. So,

Microsoft is performing well compare to the industry, but still could improve even better compared

to S&P 500.

Table 6 Microsofts Inventory Turnover Ratio


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Inventory Turnover 2001 2002 2003 2004 2005 Industry S&P 500

Number of day 41.63 7.71 9.47 15.95 12.63 28.4 8.4

The same kind of logic could be applied to the account receivables to determine the number

of days between sales to the time it is collected in cash. The longer the operating cycle, the more

current assets are needed to cover current liabilities. Thus, it is important to know how long it takes

to convert inventories and account receivables into cash. The following table 7 shows the

Microsofts number of days it takes to collect account receivables. One can notice that in 2001 it

took Microsoft 52.97 days to collect receivables and in 2002 it went up to 66 days. By 2003, there

is an improvement of 7 days staying at 58.92 days. In 2004, there isnt any significant change, but

by the year 2005, it went up by 7 days and stayed at 65.87 days.

Table 7 Microsofts Average Collection Period

Number of Days receivables 2001 2002 2003 2004 2005

Number of days 52.97 66.00 58.92 58.36 65.87

Measures of liquidity

Brigham & Houston (2004) explained that liquidity ratios provide a measure of firms

ability to generate cash to meet its immediate needs. There are three liquidity rations:

1. The current ratio is the ratio of current assets to current liabilities indicating a firms

ability to satisfy its current liabilities with its current assets. The latest Microsofts current ratio is

2.89. The industrys current ratio is 2.3, and S&P500 is 1.4. This is well beyond the Industry and

S&P 500.

Table 8 Microsofts Current Ratio


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2001 2002 2003 2004 2005 Industry S&P 500

Current Ratio 4.24 3.81 4.22 4.71 2.89 2.3 1.4

2. The quick ratio is the ratio of quick assets to current liabilities indicating a firms ability

to satisfy its current liabilities with its current assets. The quick ratio is 2.86 and above the Industry

of 2.1 and S&P 500 of 1.0.

Table 9 Microsofts Quick Ratio

2001 2002 2003 2004 2005 Industry S&P 500

Quick Ratio 4.23 3.76 4.17 4.69 2.86 2.1 1.0

3. The net working capital to sales ratio is the ratio of net working capital to sales indicating

a firms liquid assets relative to its need for liquidity.

Table 10 Microsofts Net Working Capital to Sales Ratio

2001 2002 2003 2004 2005

Net Working Capital to Sales 1.18 1.26 1.40 1.51 0.80

The larger the liquidity ratios are, the better the firms position to meet its immediate

financial obligations. The Microsofts liquidity ratios are showing increasing liquidity from 2001 to

2004, but it is weakening in 2005.

Profitability Ratios

Brigham & Houston (2004) defined that the profitability ratios compare components of

income with sales. There are three ratios to consider: 1) gross profit margin, 2) operating profit

margin, 3) net profit margin, 4) return on total assets, 5) return on common equity.


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1. The gross profit margin is the ratio of gross income to sales. This ratio shows how much

of every dollar of sales is left after costs of good sold.

2. The operating profit margin is the ratio of operating profit to sales. This is a ratio that

represents how much of each dollar of sales is left over operating expenses.

3. The net profit margin is the ratio of net income to sales and indicates how much of each

dollar of sales is left over after all expenses.

4. The ratio of net income to total assets measures the return on total assets (ROA) after

interest and taxes.

5. The bottom line accounting ratio is the ratio of net income to common equity, which

measures the return on common equity (ROE).

Table 11 Microsofts Profitability Ratios

Profitability Ratios 2001 2002 2003 2004 2005 Industry S&P 500

Gross profit 86.34% 81.70% 81.18% 81.77% 84.42% 82.6% 47.3%

Operating profit

margin 46.33% 41.99% 29.65% 24.53% 36.60%

32.5% 12.4%

Net profit margin 29.04% 27.60% 23.40% 22.17% 30.80% 23.5% 8.5%

ROA 12.49% 11.57% 9.21% 8.66% 17.30% 13.9% 2.9%

ROE 15.53% 15.00% 11.60% 10.92% 25.47% 22.6% 16.3%

Table 11 shows the Microsofts profitability ratios compared to the Industry and the S&P 500.

Indeed, the Microsoft Corporation is profitable and leads not only the rivals, but also S&P 500.

Activity Ratios

Brigham & Houston (2004) showed that the activity ratios are measures of how well assets

are used.


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1. Accounts receivable turnover is the ratio of net credit sales to account receivable. This

ratio indicates how many times in the period credit sales have been created and collected on.

2. Total asset turnover is the ratio of sales to total assets. This ratio indicates the extent that

the investment in total assets results in sales. There is some room for improvement in term of

account receivable turnover. In year 2005, this ratio was at 5.54 for Microsoft compare to the

industry rate of 5.2. In other hand, the total asset turnover is better than the industry but above the

S&P 500.

Table 12 Microsofts Activity Ratios

Activity Ratios 2001 2002 2003 2004 2005 Industry S&P 500

Account receivable turnover 6.89 5.53 6.19 6.25 5.54 5.2 7.5

Total Asset Turnover 0.43 0.42 0.39 0.39 0.56 0.6 0.3

Financial Leverage Ratios

A firm uses equity or debt to finance its assets. If the firm decides to use debt, then this

introduces the financial risk to its operations, since the firm is legally obligated to pay interest and

to repay the principal as promised. If the firm decides to use equity financing, then it doesnt

legally obligate the firm to pay anything except it might have to pay the dividends which are at the

discretion of the board of directors. Brigham & Houston (2004) argue that financial leverage ratios

are used to assess how much financial risk the company has taken on. There are two types of

financial leverage ratios: component percentages and coverage ratios.

Component-percentage financial leverage ratios

1. The total debt to assets ratio indicates the proportion of assets that are financed with debt.

2. The long-term debt to assets ratio shows the proportion of the firms assets that are

financed with long-term debt. Microsoft doesnt have long term debt.


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3. The debt to equity ratio indicates the relative uses of debt and equity as sources of capital

to finance the firms assets, evaluated using book values of the capital sources.

Table 13 Microsofts Financial Leverage Ratios

2001 2002 2003 2004 2005

Total debt to assets ratio 19.62% 22.86% 20.58% 20.71% 32.06%

Total debt to equity ratio 24.41% 29.64% 25.91% 26.12% 47.18%

Coverage financial leverage ratios

Brigham & Houston (2004) defined that the times-interest-coverage ratio compares the

earnings available to meet the interest obligation with the interest obligation.

Table 14 Microsofts Coverage Financial Leverage Ratios

Coverage financial leverage 2001 2002 2003 2004 2005

Times-interest-coverage -60.10 -30.00 6.33 2.86 7.04

Shareholder Ratios

Brigham & Houston (2004) argued that shareholder ratios demonstrate the overall results of

business operations so they can be compared in terms of a share of stock. There are two numbers of

earnings per share reported by companies: basic and diluted. Basic earnings per share are calculated

using reported earnings and the average number of share outstanding. Diluted earnings per share

are computed assuming that all potentially dilutive securities are issued. The table 15 shows both

the basic and diluted earnings per share ratio.

Table 15 Microsofts EPS

Earnings Per Share 2001 2002 2003 2004 2005


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Basic $0.69 $0.72 $0.70 $0.76 $1.13

Diluted $0.66 $0.70 $0.69 $0.75 $1.12

The difference between the basic and diluted earnings per share could be attributed to the

use of stock options in compensation programs.

Price-earnings ratio

Brigham & Houston (2004) stated that the price-earnings ratio (P/E or PE ratio) is the

ratio of the price per share of common stock to the earnings per share of common stock.

Table 16 Microsofts P/E Ratio

2001 2002 2003 2004 2005 Industry S&P 500

Price/Earnings Ratio 97 71 40 36 23 27.3 18.4

P/E is used to analyze the companys ability to generate cash flows in the future. The

following table (MSFT, 2006) is a snapshot of top application software companies by market cap

as of March 4th, 2006.

Table 17 Snapshot of top application software companies

Company Symbol Price Change Market Cap P/E

Microsoft Corp. MSFT 26.9 -0.15% 278.28B 22.26

Oracle Corp. ORCL 12.8 -0.08% 66.02B 23.25

SAP AG SAP 52.1 0.85% 64.54B 35.93

Adobe Systems Inc. ADBE 39.1 0.62% 23.42B 32.9

CA INC. CA 27 0.07% 15.59B 76.27

Intuit Inc. INTU 48.6 0.35% 8.60B 21.31


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Financial Analysis and Benchmarking

Based on the income statement analysis from Exhibit 2, the Microsofts revenue has been

growing at a rate of 13% on average every year. In this highly competitive market segment, this

growth rate is solid.

In fiscal year 2005, the Microsoft Corporation invested 16% of its revenue in research

and development (Exhibit 3). This amount was 21% in 2004, 20% in 2003, 15% in 2002, and

17% in 2001.

General and Administrative expenses show a steady increase from 3% in 2001, 5% in

2002, 8% in 2003, and all of sudden 14% in 2004! This is due to legal expenses of $1.92 billion

to settle the Sun Microsystems case, a $605 million fine imposed by the European Commission,

and $280 million of stock-based compensation (CNN, 2006). In 2005, General and

Administrative expenses were reduced to 10%.

Based on Microsofts Balance Sheet (Exhibit 4), the company has $37.751 billion in cash

and short-term investments. Microsoft doesnt have long term debt, but they do have short-term

loans and liabilities. The fiscal year 2005, the value of Microsofts current liabilities was $22.7

billion. Although, there is an increase in short-term liabilities in 2005, Microsofts has 1.66

times the cash necessary to payoff its short-term debt without tapping to its account receivables

and other assets.

The working capital can be known by subtracting the current assets of $48,737 billion

from the current liabilities at $22,700 billion. Therefore, the working capital is $26,037 billion.

Based in Balance Sheet (Exhibit 4) there are 10,710 billion shares outstanding in 2005. So, the

working capital per share is $2.41. MSN Money Central (2006) lists the Microsoft stock around

$27.00.


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In fiscal year 2005, the current ratio was 2.89 compare to 4.71 in 2004. One can see

continual improvement efficiency. Specially, the Microsoft using its cash to launch new

operation system named Vista and planned to be released for consumer market in 2007.

In term of quick ratio as of year 2005, Microsoft has $2.86 in current assets for every $1

in liabilities. This is a good financial position. But, the quick ratio has deteriorated in year 2004

from 4.69 to 2.86 in year 2005.

Direct Competition Comparison

Microsoft is in direct competition with many high technology companies. This is due to

the vast products and services that Microsoft is developing for many segments of activities.

MSFT (2006) indicated in table 18 some of the major direct competitors of Microsoft.

Table 18 Microsofts Direct Competition

Microsoft Google IBM Oracle

Market Cap: 289.43B 137.80B 131.37B 64.58B

Employees: 61,000 3,021 348,052 49,872

Quarterly Revenue Growth: 6.00% 95.90% -7.80% 19.40%

Revenue: 40.34B 5.25B 94.38B 12.89B

Gross Margin: 85.01% 57.15% 39.17% 76.83%

EBITDA: 17.95B 2.24B 18.48B 5.01B

Operational Margins: 42.19% 33.93% 14.14% 33.62%

Net Income: 12.87B 1.30B 8.57B 2.88B

EPS: 1.184 4.514 5.160 0.550

P/E: 22.96 103.29 16.12 22.75

PEG (5 yr expected): 1.67 2.67 1.48 1.38


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P/S: 7.16 26.10 1.40 5.01

Microsoft is ranked number one in term of sales and its net income is the highest. The

future financial growth seems to be strong. Microsoft is subject to fierce competition not only

from its arch commercial rivals such as IBM, Oracle, Sun Microsystems, but also from non-

commercial software developers. These companies are developing open source software at

nominal cost and earn their revenue by providing software customization or service support. A

good example of this open source software is the operating system Linux. Another example is

Open Office which can be used to replace Microsoft Office Productivity Suites.

Microsofts own success has become a handicap, since many hackers are focusing their

attentions to break into Microsoft software products causing security issues.

Microsoft is using its intellectual capital as a competitive advantage to respond to these

threats. The introduction of new generation of 64 bits operating system called Windows Vista is

scheduled to be offered to the public for the fiscal year 2007 (Microsoft 2006). Foley (2006)

reported that on February 2006, Microsoft has invited hundreds of Technology Adoption

Partners to come to the Redmond for the beta testing of Windows Vista.

Microsoft is releasing in 2006 major updates of several products including new version of

its database management system called SQL Server, an integrated software development

environment called Visual Studio, and a middle ware called Biz Talk Server. Microsoft is

preparing to introduce new wave of products, code named Office 12, to be released during the

first half of fiscal year 2007 (Microsoft 2006).

Microsoft Business Solutions has already released a major product upgrade for Microsoft

CRM version 3.0 to address the needs of small and mid-size firms to manage their customers


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relationship and marketing efforts. Other enhancements include products such as Microsoft

Axapta, Microsoft Great Plains, Microsoft Navision and Microsoft Solomon (Microsoft 2006).

In 2006, Microsoft Mobile and Embedded Devices division expects to release added

functionality to the Windows Mobile 5.0 platform through the Microsoft Enterprise Feature Pack

and the Extended Service Pack 2. (Microsoft, 2006, p.10)

Microsoft Xbox went through a major upgrade in May 2005 and it will be introduced in

the first half of 2006 in European Market (Microsoft 2006).

Recommendations

Microsofts current stock pricing levels appears slightly undervalued compare to its

peers. It is recommended, based on current data and future expectations for growth, to buy this

stock or at least to hold for future upside. But, it is important to notice that Microsoft is no

longer the prototypical growth stock. The shares are 47% below their all-time-high reached in

the year 1999. This year stock price is around $27 and profits are continuing to grow. The year-

ahead earnings are $1.43 per share. The balance sheet includes $4 per share in cash. There is

expectation of 13% earnings growth this year. In term of new products offering, Microsoft is

marketing its Xbox 360 game player in US and Europe, the Windows Vista and new Microsoft

Office products are in beta release and will be ready for mass market in 2007. Business Week

(2005) listed the Microsoft Corporation brand as number two in its top 100 brands just behind

Coca Cola. This brand recognition is due to the Microsoft Corporation management philosophy

which is centered on the innovation and forward looking business strategy by designing new

products and services using their strong market position on Windows platforms. Their

competitive advantage is a source of litigation by other software development companies and

ongoing governments scrutiny in United States and European Union. But, Microsoft is fighting

back and tried to settle most of these litigations out of the court. This has a direct impact on their


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net income and profitability. With the anticipated release of Windows Vista in 2007, we could

expect higher earnings momentum.

Conclusion

Microsoft carries a positive rating. Based on ratio analysis and benchmarking with its

competitors, the current valuation of stock seems undervalued. There is a potential for future

growth, thus holding on Microsoft stock is very attractive in any portfolio. A target price of $29

per share is reasonable and we highly recommend buying it.


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References

Big Charts (2006). Microsoft Corporation Stock Price Movements form 2001 to 2005.

Retrieved March 2, 2005, From

http://bigcharts.marketwatch.com/intchart/frames/frames.asp?symb=msft&time=&freq=

Brigham, E. F., & Houston, J. F. (2004). Fundamentals of Financial Management (4th ed.)

Mason: Thomson.

Business Week (2005). The 100 top brands. Business Week, 8/1/2005, 3945, p. 90-94.

CNN (2006). Microsoft Stock Quote Report. Retrieved February 4, 2006 from

http://money.cnn.com/quote/quote.html?symb=MSFT.

Foley, M. J. (2006). Vista coming into focus. Retrieved February 4, 2006 from

http://www.eweek.com/article2/0,1759,1928056,00.asp.

MSFT (2006). Retrieved February 4, 2006 from http://finance.yahoo.com/q?s=MSFT.

Microsoft (2006). 2005 Microsoft Annual Report, retrieved February 28, 2006 from

http://www.microsoft.com/msft/ar.mspx.

MSN Money Central (2006). MSFT Chart, Retrieved February 4, 2006 from

http://moneycentral.msn.com/investor/charts/chartdl.asp?Symbol=MSFT.


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Exhibit 1- Microsoft Corporation Income Statement (In million except per share data)

INCOME STATEMENT 2001 2002 2003 2004 2005 Revenue $25,296 $28,365 $32,187 $36,835 $39,788 Operating Expenses: Cost of revenue $3,455 $5,191 $6,059 $6,716 $6,200 Research & development $4,379 $4,307 $6,595 $7,779 $6,184 Sales & marketing $4,885 $5,407 $7,562 $8,309 $8,677 General & administrative $857 $1,550 $2,426 $4,997 $4,166 Total Operating Expenses $13,576 $16,455 $22,642 $27,801 $25,227 Operating Income $11,720 $11,910 $9,545 $9,034 $14,561 Investment income/ (loss) and other ($195) ($397) $1,509 $3,162 $2,067 Income before income and taxes $11,525 $11,513 $11,054 $12,196 $16,628 Provision for income taxes $3,804 $3,684 $3,523 $4,028 $4,374 Income before accounting change $7,721 $7,829 $7,531 $8,168 $12,254 Effect of accounting change ($375) $0 $0 $0 $0 Net Income $7,346 $7,829 $7,531 $8,168 $12,254 Earning per share: Basic $0.69 $0.72 $0.70 $0.76 $1.13 Diluted $0.66 $0.70 $0.69 $0.75 $1.12 Weighted average shares outstanding: Basic 10,683 10,811 10,723 10,803 10,839 Diluted 11,148 11,106 10,882 10,894 10,906Dividends per share $0 $0 $0.08 $0.16 $3.33Book value per share $4.43 $4.83 $6.05 $6.93 $4.44Cash flow per share $0.83 $0.82 $0.83 $0.87 $1.21


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Exhibit 2 Microsoft Corporation Income Statement Percentage of Change

INCOME STATEMENT From 2001 to 2002

From 2002 to 2003

From 2003 to 2004

From 2004 to 2005

Average

Revenue 10.82% 11.87% 12.62% 7.42% 10.68%Operating Expenses: Cost of revenue 33.44% 14.33% 9.78% -8.32% 12.31% Research & development

-1.67% 34.69% 15.22% -25.79% 5.61%

Sales & marketing 9.65% 28.50% 8.99% 4.24% 12.85% General & administrative

44.71% 36.11% 51.45% -19.95% 28.08%

Total Operating Expenses 17.50% 27.33% 18.56% -10.20% 13.29%

Operating Income 1.60% -24.78% -5.66% 37.96% 2.28% Investment income/ (loss) and other

50.88% 126.31% 52.28% -52.98% 44.12%

Income before income and taxes

-0.10% -4.15% 9.36% 26.65% 7.94%

Provision for income taxes

-3.26% -4.57% 12.54% 7.91% 3.16%

Income before accounting change

1.38% -3.96% 7.80% 33.34% 9.64%

Effect of accounting change

Net Income 6.17% -3.96% 7.80% 33.34% 10.84% Earning per share: Basic 4.17% -2.86% 7.89% 32.74% 10.49% Diluted 5.71% -1.45% 8.00% 33.04% 11.33% Weighted average shares outstanding:

Basic 1.18% -0.82% 0.74% 0.33% 0.36% Diluted -0.38% -2.06% 0.11% 0.11% -0.55%


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Exhibit 3 Microsoft Corporation Common Size Income Statement

INCOME STATEMENT

2001 2002 2003 2004 2005 Revenue 100% 100% 100% 100% 100% Operating Expenses: Cost of revenue 14% 18% 19% 18% 16% Research and development

17% 15% 20% 21% 16%

Sales & marketing 19% 19% 23% 23% 22% General & administrative

3% 5% 8% 14% 10%

Total Operating Expenses 54% 58% 70% 75% 63%

Operating Income 46% 42% 30% 25% 37% Investment income /(loss) and other

-1% -1% 5% 9% 5%

Income before income and taxes

46% 41% 34% 33% 42%

Provision for income taxes

15% 13% 11% 11% 11%

Income before accounting change

31% 28% 23% 22% 31%

Effect of accounting change

-1% 0% 0% 0% 0%

Net Income 29% 28% 23% 22% 31%


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Exhibit 4 Microsoft Corporation Balance Sheet (In millions)

BALANCE SHEET 2001 2002 2003 2004 2005 Current Assets: Cash and Short Term Investments $31,600 $38,652 $49,048 $60,592 $37,751 Total Receivables, Net $3,671 $5,129 $5,196 $5,890 $7,180 Total Inventory $83 $673 $640 $421 $491 Other Current Assets, Total $3,856 $4,122 $4,089 $3,663 $3,315 Total Current Assets $39,210 $48,576 $58,973 $70,566 $48,737 Property/Plant/Equipment, Total - Net $2,309 $2,268 $2,223 $2,326 $2,346 Goodwill, Net $1,511 $1,426 $3,128 $3,115 $3,309 Intangibles, Net $401 $243 $384 $569 $499 Long Term Investments $14,361 $14,191 $13,692 $12,210 $11,004 Other Long Term Assets, Total $1,038 $942 $3,332 $5,582 $4,920 Total Assets $58,830 $67,646 $81,732 $94,368 $70,815 Current Liabilities: 2001 2002 2003 2004 2005 Accounts Payable $1,188 $1,208 $1,573 $1,717 $2,086 Accrued Expenses $742 $1,145 $1,416 $1,339 $1,662 Other Current Liabilities $7,324 $10,391 $10,985 $11,913 $13,129 Total Current Liabilities $9,254 $12,744 $13,974 $14,969 $16,877 Deferred Expenses $409 $398 N/A N/A N/A Other Liabilities, Total $1,878 $2,324 $2,846 $4,574 $5,823 Total Liabilities $11,541 $15,466 $16,820 $19,543 $22,700 Common Stock, Total $28,390 $31,647 $49,234 $56,396 $60,413 Retained Earnings (Accumulated Deficit) $18,899 $20,533 $15,678 $18,429 ($12,298)Total Equity $47,289 $52,180 $64,912 $74,825 $48,115 Total Liabs. & Stockholders' Equity $58,830 $67,646 $81,732 $94,368 $70,815 Total common Share Outstanding 10,766 10,718 10,771 10,862 10,710


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Exhibit 5 Microsoft Corporation Balance Sheet (Percent of Assets)

BALANCE SHEET 2001 2002 2003 2004 2005

Current Assets: Cash and Short Term Investments 53.7% 57.1% 60.0% 64.2% 53.3% Total Receivables, Net 6.2% 7.6% 6.4% 6.2% 10.1% Total Inventory 0.1% 1.0% 0.8% 0.4% 0.7% Other Current Assets, Total 6.6% 6.1% 5.0% 3.9% 4.7%Total Current Assets 66.6% 71.8% 72.2% 74.8% 68.8% Property/Plant/Equipment Total - Net 3.9% 3.4% 2.7% 2.5% 3.3% Goodwill, Net 2.6% 2.1% 3.8% 3.3% 4.7% Intangibles, Net 0.7% 0.4% 0.5% 0.6% 0.7% Long Term Investments 24.4% 21.0% 16.8% 12.9% 15.5% Other Long Term Assets, Total 1.8% 1.4% 4.1% 5.9% 6.9%Total Assets 100.0% 100.0% 100.0% 100.0% 100.0% Current Liabilities: 2001 2002 2003 2004 2005 Accounts Payable 2.0% 1.8% 1.9% 1.8% 2.9% Accrued Expenses 1.3% 1.7% 1.7% 1.4% 2.3% Other Current Liabilities 12.4% 15.4% 13.4% 12.6% 18.5%Total Current Liabilities 15.7% 18.8% 17.1% 15.9% 23.8% Deferred Expenses 0.7% 0.6% N/A N/A N/A Other Liabilities, Total 3.2% 3.4% 3.5% 4.8% 8.2%Total Liabilities 19.6% 22.9% 20.6% 20.7% 32.1% Common Stock, Total 48.3% 46.8% 60.2% 59.8% 85.3% Retained Earnings (Accumulated Deficit) 32.1% 30.4% 19.2% 19.5% -17.4%Total Equity 80.4% 77.1% 79.4% 79.3% 67.9%Total Liabs. & Stockholders' Equity 100.0% 100.0% 100.0% 100.0% 100.0%


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Exhibit 6 Microsoft Corporation Statement of Cash Flows (In millions)

CASH FLOW FROM OPERATING ACTIVITIES 2001 2002 2003 2004 2005 Net Profit After Taxes $7,346 $7,829 $7,531 $8,168 $12,254 Cumulative effect of accounting change, net of tax $375 $0 $0 $0 $0 Depreciation $1,536 $1,084 $1,393 $1,186 $855 Stock-based compensation $0 $2,424 $3,749 $5,734 $2,448 Net recognized (gains)/losses on investments $2,221 $1,596 $380 ($1,296) ($527)Stock option income tax benefits $2,066 ($416) $1,365 $1,100 $668 Deferred income taxes ($420) $11,152 ($894) ($1,479) ($179)Unearned revenue $6,970 ($8,929) $12,519 $11,777 $13,831 Recognition of unearned revenue ($6,369) ($1,623) ($11,292) ($12,527) ($12,919)Account receivable ($418) ($264) $187 ($687) ($1,243)Other current assets ($482) ($9) $412 $478 ($245)Other long-term assets ($330) $1,449 ($28) $34 $21 Other current liabilities $774 $216 $35 $2,063 $396 Other long-term liabilities $153 $440 $75 $1,245 Net Cash Flow from Operations $13,422 $14,509 $15,797 $14,626 $16,605 Financing Common stock issued 1,620 1,497 2,120 2,748 3,109 Common stock repurchased ($6,074) ($6,069) ($6,486) ($3,383) ($8,057) Repurchase of put warrants ($1,367) $0 $0 $0 $0 Common stock cash dividends $0 $0 ($857) ($1,729) ($36,112) Other $235 $0 0 0 ($18)Net cash used for financing ($5,586) ($4,572) ($5,223) ($2,364) ($41,078) Investing Additions to property and equipment ($1,103) ($770) ($891) ($1,109) ($812) Acquisitions of companies, net of cash required $0 $0 ($1,063) ($4) ($207) Purchase of investments ($66,346) ($89,386) ($91,869) ($95,005) ($68,045) Maturities of investments $5,867 $8,654 $9,205 $5,561 $29,153 Sales of investments $52,848 $70,657 $77,123 $87,215 $54,938 Net cash used for investing ($8,734) ($10,845) ($7,495) ($3,342) $15,027 Net change in cash and equivalents ($898) ($908) $3,079 $8,920 ($9,446)


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Effect of exchange rates on cash and equivalents ($26) $2 $61 $27 ($7)Cash and equivalents, beginning of period 4846 3922 2217 5357 14304Cash and equivalents, end of period $3,922 $3,016 $5,357 $14,304 $4,851

Exhibit 7 Microsoft Corporation Ratio Analysis

2001 2002 2003 2004 2005Current Ratio 4.24 3.81 4.22 4.71 2.89Quick Ratio 4.23 3.76 4.17 4.69 2.86 Inventory Turnover 41.63 7.71 9.47 15.95 12.63Average Collection Period 52.97 66.00 58.92 58.36 65.87 Total Asset Turnover 0.43 0.42 0.39 0.39 0.56 Debt Ratio 0.20 0.23 0.21 0.21 0.32Debt-to-Equity 0.04 0.04 0.04 0.06 0.12Times Interest Earned -60.10 -30.00 6.33 2.86 7.04 Gross Profit Margin 86.34% 81.70% 81.18% 81.77% 84.42%Operating Profit Margin 46.33% 41.99% 29.65% 24.53% 36.60%Net Profit Margin 29.04% 27.60% 23.40% 22.17% 30.80% Return on Total Assets (ROA) 12.49% 11.57% 9.21% 8.66% 17.30%Return on Equity (ROE) 15.53% 15.00% 11.60% 10.92% 25.47% Earnings Per Share $0.68 $0.73 $0.70 $0.75 $1.14 Price/Earnings Ratio 6.21 5.22 6.04 6.27 2.52

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